Is Sinopec Oilfield Service (HKG:1033) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Sinopec Oilfield Service Corporation (HKG:1033) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Sinopec Oilfield Service

What Is Sinopec Oilfield Service's Net Debt?

The chart below, which you can click on for greater detail, shows that Sinopec Oilfield Service had CN¥19.5b in debt in March 2023; about the same as the year before. However, it does have CN¥1.84b in cash offsetting this, leading to net debt of about CN¥17.7b.

How Strong Is Sinopec Oilfield Service's Balance Sheet?

The latest balance sheet data shows that Sinopec Oilfield Service had liabilities of CN¥62.3b due within a year, and liabilities of CN¥1.27b falling due after that. On the other hand, it had cash of CN¥1.84b and CN¥31.2b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥30.6b.

This is a mountain of leverage relative to its market capitalization of CN¥32.4b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While Sinopec Oilfield Service's debt to EBITDA ratio (3.8) suggests that it uses some debt, its interest cover is very weak, at 2.2, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The good news is that Sinopec Oilfield Service grew its EBIT a smooth 49% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sinopec Oilfield Service's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Sinopec Oilfield Service actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Sinopec Oilfield Service's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. But truth be told its interest cover had us nibbling our nails. Looking at all this data makes us feel a little cautious about Sinopec Oilfield Service's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Sinopec Oilfield Service is showing 1 warning sign in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.